February 2019 Reporting Season Wrap

Articles 6/03/2019

Considering the bout of market volatility heading into Christmas, February's Australian company reporting season was a timely update on corporate operating conditions. As reporting season has concluded, markets have bounced back with little sign of the pre-Christmas sentiment in markets.

Heading into February, corporate earnings expectations had been downgraded on the back of slowing global growth, geopolitical uncertainty and a continued softening in Australia's housing market.

So downbeat were expectations that earnings per share (EPS) growth for the Australian share market for the 2019 financial year was shaping up to be the weakest in 3 years at only 4%. With commodity prices remaining strong, this masked an even weaker picture. Excluding Resource companies and Banks, the balance of the ASX200 was forecast to deliver a meagre 1% EPS growth. 

Behind this though, performances were widely dispersed. Results highlighted a number of companies well placed to deliver consistent growth well in excess of the 1% EPS growth referred to above. 

Pleasingly, our Australian equity investments performed well with few surprises as they continue to deliver on our investment thesis.

In reviewing the results, we looked for clarity on a number of big picture questions.

What impact will falling east coast property prices and a rapid fall in residential construction activity have on the broader economy?

Various indicators of building activity in the housing market continue to soften, particularly in high density (apartments). As illustrated below, approvals for apartment developments (brown line in the chart below) indicate a further softening in activity lies ahead.


   

 

While this may not materially impact 2019 corporate earnings, we remain wary of their impact in 2020 with Australian retailers and building companies likely to be most impacted. In addition, a weaker housing construction market may also see higher unemployment as the pipeline of work dries up (construction jobs account for ~10% of the workforce). To date we have not been overly concerned about weakening house prices but a combination of house price declines and rising unemployment would incentivise households to save rather than spend – this would be a risk for the economy and one we will be monitoring closely over coming months.

Turning to company results, Stockland's residential development business delivered a robust performance in the face of the broader industry headwinds. Facing land price reductions of 10% in NSW and 5% in Victoria, the business was able to maintain solid margins thanks to its strategy of focussing on more affordable locations and the resilient first home buyer market.

Meanwhile Bunnings' (now contributing over 50% of Wesfarmers' earnings) resilience shone through with continued sales growth and further margin expansion. Management did however warn of tougher operating conditions ahead.

Plumbing fittings manufacturer Reliance demonstrated that strength comes from diversification. Not only are its products sold primarily into the resilient 'renovation and repairs' market, its focus on the American and European markets have allowed it to continue generating double-digit profit growth.

How is the domestic consumer faring in the face of a prolonged period of weak wage growth and ever-increasing costs of living?

Both major supermarket chains reported undeniably weak results, highlighting that not even grocers are immune from the impacts of a budget-conscious consumer. Price competition remains rampant, driven by the large offshore operators of Aldi, Costco and Amazon. We don't see the situation improving anytime soon with both Coles and Woolworths' management seemingly agreeing by downgrading guidance. Thankfully, we had proactively exited our Coles positions and materially reduced our Woolworths holdings prior to these events.

Kmart (about 20% of Wesfarmers' earnings) also delivered a soft result showing a downward shift in momentum albeit following many years of strong growth. We continue to watch how Wesfarmers management will balance a turnaround in Target against maintaining the strong profitability in Kmart.

There does however, remain some bright spots in the retail landscape. Automotive parts supplier, Bapcor showed that while consumers can tighten the purse strings, they can only defer a car service for so long.  4WD accessory manufacturer ARB continues to demonstrate its ability to deliver a superior product into offshore markets, helping to offset any softness at home.

We continue to favour stocks exposed to non-discretionary household spending, namely healthcare.  Ramsay continues to demonstrate its strength as the leading private hospital operator in Australia, growing earnings despite pressure in the private health insurance market. Meanwhile global pathology business Sonic is on the cusp of delivering material synergies from a large US acquisition and Invocare's funeral operations appear to be rebounding strongly through a period of refurbishment at its parlours. We expect these stocks to continue performing irrespective of the pressures on households.

Will dividends and other forms of capital management continue to positively surprise? How will companies pre-empt the Australian Labor Party's proposed franking credit policy?

Management across a variety of industries looked to sweeten otherwise modest results by increasing returns to shareholders. A number of companies paid substantially higher dividends than normal. This was likely influenced by Labor's proposed changes to the treatment of franking credits.

Wesfarmers paid a special dividend, returning surplus capital to shareholders following its demerger of Coles. Woodside also materially increased its dividend, handing back excess cashflows brought about by a step-up in its LNG volumes and global gas prices. Global pallet pooler, Brambles also paid a higher-than-usual level of franking.  Both BHP and Woolworths have either conducted or are in the process of returning large franking credit balances via off-market share buybacks.

While the one-off increase in shareholder dividends were a welcome development for many of our Australian equity holdings, we continue to progressively reallocate incremental capital towards international equities. Not only does this serve to reduce our portfolio's exposure to franking credit (and other) policy shifts, but it also increases our exposure to opportunities where we see superior income and growth prospects.

What industries remain most at risk of policy and regulatory uncertainty?

The Banking Royal Commission dominated headlines early in the month. Unless you were a mortgage broker, NAB Chairman Ken Henry or CEO Andrew Thorburn, Commissioner Hayne handed down a report that appeared to take a light-handed approach to the major banks.

Bank share prices have since rallied with the focus returning to valuations which were beaten up ahead of the final report. While the earnings growth outlook remains soft, dividends should be maintained (apart from NAB, which remains our least preferred bank exposure). Pleasingly, recent stress tests conducted by both Australia's prudential regulator, APRA and the International Monetary Fund indicate our major banks have incredibly strong balance sheets, more than capable of managing a housing crisis akin to the US sub-prime collapse of 2007. This conclusion supports our holding of bank hybrid securities.

One company we continue to see as a key beneficiary from the Royal Commission is independent platform provider Netwealth. For every $1 added to an investment platform over the last 12 months, 52 cents has gone to Netwealth. It continues to take market share as advisers further distance themselves from relationships with larger incumbents like AMP and IOOF.

Unfortunately for electricity retailers and aged care operators, their industries will remain political footballs in the lead-up to the Federal Election. We continue to carefully monitor developments.

 

While the vast majority of our companies performed well, we continue to take a conservative approach to portfolio management. Given our expectation for periods of market volatility, we continue to realise profits in selected names while patiently waiting for attractive investment opportunities to present themselves.

Our stringent focus on the preservation of capital remains unwavering.

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